Executive Summary
In autumn 2008, Britain's banking system came perilously
close to collapse. To avert catastrophe, the Government was forced
to step in with multi-billion pound bailouts. Many factors led
to this crisis including failings in financial supervision and
fuzzy allocation of responsibilities for preventing and managing
systemic crises.
The draft Financial Services Bill is aimed at preventing
such a potentially calamitous systemic failure of the financial
sector occurring again. It proposes far reaching changes to the
regulatory structure, replacing the tripartite system of financial
regulation with a twin peaks model. Our recommendations are intended
to ensure that the new regulatory authorities have the right objectives,
powers and responsibilities and systems of accountability which
will be essential to make them effective.
The draft Bill gives unprecedented new powers to
the Bank of England. The Bank will now have substantial powers
to manage the British economy not only through monetary policy
but also by directly influencing risk-taking in financial markets
and influencing the supply of credit. It will have access to measures
impinging directly on households and businesses. This raises important
issues of democratic accountability to Parliament. We make recommendations
to ensure that the Treasury and Parliament will exercise more
oversight of the new Financial Policy Committees' macro-prudential
activities. The Bank's powers also demand a new governance structure
for the Bank itself and we recommend that the Court of Directors
be replaced by a Supervisory Board, some members of which would
have direct experience of the financial sector. The new Board
should have powers to review the performance of the new Financial
Policy Committee and its chairman would be consulted on the appointment
of a new Governor.
The new Financial Policy Committee should become
a committee of the Bank under the new Supervisory Board, with
equal status to the MPC. FPC membership must be broadened to include
experts from across financial services, including insurance, and
the wider economy. Bank of England staff should lose their proposed
majority on the FPC to external members. Reports on major regulatory
failure, like the recent report of the collapse of RBS, should
be standard practice. The PRA should have an independent complaints
commissioner who handles complaints against both the PRA and the
FCA.
It must be clear, however, that if there is a potential
banking failure, and the possibility of demands on the public
finances, then it is a matter for Government. The evidence we
received made clear that in the last crisis, there was confusion
as to who was in charge. Our recommendations intend to remove
any doubt: when there is a threat to public funds, the Governor
must alert the Chancellor who must then lead the response.
No regulatory structure can completely rule out bank
failure but the likelihood and potential impact can be minimised.
The Independent Commission on Banking's recommendations on ring-fencing
of retail banking from riskier investment banking arms should
receive thorough pre-legislative scrutiny. Subject to that we
recommend that legislation enacting the proposals on ring-fencing
should be brought forward in the next session of Parliament, with
a view to implementation at the earliest possible date. The Government
should think very carefully about imposing on banks headquartered
in the UK capital requirements relating to their overseas subsidiaries
over and above that agreed by the international college of regulators
monitoring those banks.
The financial sector, however, now extends far beyond
the ranks of banks. MF Global, the recently failed US futures
broker, would not have come within the regulatory perimeter as
envisaged for the new Prudential Regulatory Authority. This is
not acceptable. The regulatory perimeter of the PRA should be
widened to cover investment firms of the size and significance
of MF Global; it should be flexible with changes subject to an
enhanced form of parliamentary scrutiny. The PRA's objectives
in the draft Bill restrict its supervision to firms that pose
a threat to the entire financial system. This is too limitedthe
PRA should have a secondary obligation to reduce the risk of failure
of other financial firms which can burden the financial guarantee
scheme, inconvenience, and potentially impose losses on, customers.
The regulation of market infrastructure should sit within the
PRA.
We recognise the international nature of the financial
sector and the fact that the European Union imposes an increasing
amount of the regulatory framework. The new regulatory structure
in the UK does not mirror the EU regulatory structure and with
different bodies representing the UK at different international
negotiating tables there is a danger that the UK will not speak
with one strong unified voice. We recommend a high level committee
reporting to the Chancellor and comprising representatives from
the PRA, FCA, Bank and Treasury to agree British objectives and
maximise the UK's influence in EU and international negotiations.
In recent years there have been several cases of
mass mis-selling of financial products, such as Payment Protection
Insurance. The draft Bill establishes a new conduct of business
regulator: the Financial Conduct Authority (FCA). The FCA's obligation
in the Bill to promote confidence in the UK financial system could
encourage it to conceal or ignore weaknesses that might disturb
confidence. The FCA's objective should be to focus on promoting
fair, efficient and transparent financial services markets that
work well for users. The FCA should be given significant new competition
powers including the power to make market investigation references
to the Competition Commission and the power to hear super-complaints.
Responsibility for consumer credit should be moved from the OFT
to the FCA.
To complement the principle of 'caveat emptor' enshrined
in the draft Bill a statutory duty should be placed on firms to
treat their customers "honestly, fairly and professionally",
and the FCA should ensure that companies address conflicts of
interest and provide intelligible information, rather than accurate
but impenetrable information that leaves customers confused. Customers
have a right to know if a warning notice has been issued about
a firm's product or process so the requirement for the FCA to
consult before disclosing the fact should be removed from the
draft Bill. We also make recommendations to ensure bank customers
are made aware when, because their bank is headquartered elsewhere
in the EEA, their deposits are not covered by the Financial Services
Compensation Scheme.
The previous regulatory regime focused too much on
backward-looking mechanistic rules and did not anticipate the
evolving risks that threatened the financial system. An important
aspect of the new regulatory philosophy and culture therefore
will be 'judgment-led' supervisionwhich means being more
forward-looking in anticipating the risks that threaten the regulatory
objectives of financial stability, consumer protection and market
integrity. Despite the Government's claim that the new regulatory
approach will be based on 'judgment-led' supervision, the term
is not mentioned in the draft Bill. We propose that 'judgment-led'
supervision be given statutory backing.
The culture and ethics within the financial services
industry also need to change. Before the 2007 crisis many banks
appear to have been involved in practices that were unethical
and designed to maximise remuneration regardless of risk to the
bank let alone the economy. Supervisors, banks and shareholders
must ensure that senior staff remuneration schemes do not lead
financial institutions to take on excessive risk. The PRA and
FCA should take an active interest in this area and should rigorously
enforce the remuneration code. The Government and the regulators
should consider increasing the share of executive remuneration
that is deferred and conditional on medium term outcomes, or introducing
a concept of 'strict liability' of executives and Board members
for the adverse consequences of poor decisions, in order to ensure
that bank executives and Boards strike a different balance between
risk and return.
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